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April 29, 2005
All long-term rates fell again late this week. The benchmark 10-year T-note has broken below 4.20%, and an "origination fee" will buy a 5.50% 30-year fixed-rate mortgage.
Bond traders are placing recession bets. Not (yet) in expectation of a classic recession in which GDP growth would decline, but a "growth recession" in which GDP growth might slip to one or two percent annual, and the unemployment rate begin to increase. The rationale for a recession bet is this win-win equation: either high energy prices and a tightening Fed have already tipped over the economy, or a worsening inflation problem will force a tighter Fed and tip-over at a later date.
Evidence. This week's breakthrough bond rally started with news of a steep drop in March orders for durable goods, and gained steam on yesterday's news that 1st Quarter GDP had grown only 3.1%. That's fabulous by European or Japanese standards, but not enough to support US job growth. Internal aspects of the report were worse: "final demand" (purchases by business, government, and individuals) rose only 1.9%. The excess of 3.1% production over 1.9% demand is sitting on shelves and floors as unsold inventory, a disincentive to production in this quarter.
Second, the personal consumption expenditure deflator ("PCE"), used to convert nominal GDP to after-inflation, jumped to an annual 2.2% gain. The PCE is Mr. Greenspan's favorite, and the acceptable band for its movement is 1.5%-2.0%; if PCE is in a jailbreak, the Fed is coming no matter what collateral damage its inflation-fighting may (will) do to the rest of the economy.
In the 1970s, the Fed tried stagflation (accidentally, maybe): keep the economy going at the price of tolerating some inflation. The reward: steadily increasing inflation and deferral of ultimately greater economic sacrifice to remove it. Not this time. Donald Kohn (Fed governor, long-time Fed staffer and key advisor to Mr. Greenspan, in the running for the Chairman's job) concluded a speech last week this way: "We should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices,... nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households."
Ow. If he won't hesitate for housing, or for the increased cost of our foreign or national debt, or for Mom and Pop, presumably he won't hesitate for the stock market, either.
The bond market's win-win, economic-slowdown equation is correct. However, neither traders nor the Fed know which win will win; i.e., how tough the Fed will have to get. Some think the Fed will signal "tough-enough soon" after its meeting on Tuesday, and stop tightening at 3.50%, only three .25% moves away. I hope so, but I think there is surprising strength in the economy just under the radar.
The obvious sign of strength: the housing market is as healthy as ever. There are some signs of slowing in price-appreciation in overheated markets, but a truly weakening economy would have showed up in housing stats by now. Recession bets have cancelled any effect of a year of Fed tightening on fixed-rate mortgages; tightening has removed silly prices for ARMs, but the interest-only innovation has more than replaced the ARM loss.
Sneaky strength: tax withholdings from paychecks are running 2.5% to 6% above official wage growth, and the wage stats are supported by the employment cost index. If wages are growing slowly, if at all, and withholdings are way up, then there are a hell of a lot more people at work than payroll stats show.
Given latent strength, and a mortgage market impervious to Fed hikes in short-term rates, the hunch here is that the Fed will have to go past 3.50% but the win-win bet will keep fixed rates under control.
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